Large purchases can feel daunting, especially if they’re not in your budget. That’s where sinking funds come in. They help you plan and save for specific wants or needs.
We’ll share more about how sinking funds work and how you can start your own.
A sinking fund is a separate savings account opened for a specific need and term. Sinking funds are meant to be spent once enough funds are saved for the stated goal. They are used for planned, one-time expenses like home upgrades or lump-sum car insurance premiums.
The term "sinking" doesn't refer to anything negative about the fund; rather it refers to the decreasing amount of debt as you work toward saving for your particular goal.
Sinking funds should not be confused with emergency funds.
An emergency fund is designed to cover unexpected expenses like medical bills or loss of income. An emergency fund should always have a certain amount in it, ideally six to twelve months’ worth of living expenses.
A sinking fund is a form of a savings account. The big difference is that a sinking fund is designed around one specific future need. In contrast, a savings account is just meant to set aside money instead of spending it.
It is important to note that one can have many sinking funds — one for each planned expense. This can help maximize money usage and help achieve multiple goals at once.
A sinking fund works by establishing goals. These goals can vary in scope, but it is crucial to identify their order of importance. Your sinking funds should focus on the most important goals first. Consider how much money you can stash away out of each paycheck for each goal and how long it will take to save up for the needed amount. Now you have the basis for a sinking fund.
Sinking funds can be established for just about any planned need. However, always remember: each sinking fund must stay devoted to one expected goal to ensure optimal success.
Every sinking fund will demand a different savings goal. But, for any goal, your target amount can be established through four steps.
Payment = ( Goal x period interest rate ) / [ ( 1 + period interest rate ) ^ total periods ] - 1
If you’re not dealing with earned interest, simply divide your savings goal by your expected time period to determine your monthly contribution.
With a few straightforward steps, you can create your own sinking funds to meet your goals.
The first step of any sinking fund is to determine what you’re saving for. This goal must be specific and researched to ensure you save enough money. You should also plan the number of months you’d ideally like to take to save your desired amount, especially in time-sensitive cases like wedding sinking funds.
Next, choose if you’d like to open a new bank account. Your sinking fund should be separate from your checking account and your emergency fund.
You may wish to choose an online bank, as they traditionally offer high-yield savings accounts with interest rates up to 25 times higher than the national average. Some banks will allow you to open multiple accounts for different sinking funds, just be wary of any minimum balance requirements.
By using a bank other than your primary bank, your sinking fund will be out of sight and — ideally — out of mind, to prevent the temptation to dip into it.
Once you’ve found an account, use the above formula to determine how much you need to contribute. Be sure your goal covers all known expenses related to your needs. For example, if you’re planning a wedding there are multiple line items you need to keep in mind from the photographer to the venue.
Sinking funds can be established for many different savings needs. For example, a sinking fund can be used to set aside monthly deposits to save up for a new car. Let’s say the car you want is $20,000, including taxes and fees. And, you want to purchase it within the next four years. Some quick math would look like:
Keep in mind that savings accounts earn interest. You can use the Securities and Exchange Commission’s (SEC) savings goal calculator to get a more precise monthly contribution number, including earned interest.
For example, say your high-yield savings account has a 1.4% APY and compounds monthly. To save $20,000 in four years, you’d need to contribute about $405 per month.
If that doesn’t seem doable, it’s worth revisiting the cost of the car and the timeline in which you want to buy to make sure you can fit the purchase into your budget.
Most budget guidelines suggest devoting at least 20% of your monthly income to savings needs. Note that this includes all savings, not just your sinking fund.
An effective way to ensure you make your monthly contributions is to make your sinking fund part of your monthly budget. Either through manual or automatic transfers, you can fund your sinking fund like any other necessary monthly payment.
For your budgeting preferences, track these contributions under whatever makes sense to you. Typically, they will fall under savings categories. However, if it makes more sense to track it as a monthly payment, use that instead.
Sinking funds are more advantageous than they are a disadvantage for people who wish to work toward saving money for a specific goal.
You can have as many different sinking funds as you’d like — it depends on your own goals and if your personal finances can support your goals. Whether you have one or three sinking funds, they will only be successful if they remain untouched until their “maturity date,” or when you’ve reached your savings goal.
Be sure you aren’t stretching your finances too thin by chasing too many financial goals at once. Remember, intelligent finances can often lead to greater financial health.
Sinking funds are great tools for those looking to make large purchases without going into long-term debt. As they are fueled entirely by your own funds, the money accrued in a sinking fund comes without any strings attached.
Sinking funds not only provide powerful incentives to meet personal financial goals, but they also help teach about patience and letting your money work for you. When paired with savings accounts with higher interest rates, sinking funds can help people reach their financial goals — without adding to or impacting their debts.
Self’s Credit Builder Account can be utilized as a sinking fund starting at only $25 a month. Not only can this help you securely store your money (minus interest and fees) for whatever planned expense you have in mind, but it may also help boost your credit score by keeping you on track to make monthly payments with ease.
Disclosure: The Credit Builder Account identified in this article is an advertisement for Self products.
Ana Gonzalez-Ribeiro, MBA, AFC® is an Accredited Financial Counselor® and a Bilingual Personal Finance Writer and Educator dedicated to helping populations that need financial literacy and counseling. Her informative articles have been published in various news outlets and websites including Huffington Post, Fidelity, Fox Business News, MSN and Yahoo Finance. She also founded the personal financial and motivational site www.AcetheJourney.com and translated into Spanish the book, Financial Advice for Blue Collar America by Kathryn B. Hauer, CFP. Ana teaches Spanish or English personal finance courses on behalf of the W!SE (Working In Support of Education) program has taught workshops for nonprofits in NYC.
Our goal at Self is to provide readers with current and unbiased information on credit, financial health, and related topics. This content is based on research and other related articles from trusted sources. All content at Self is written by experienced contributors in the finance industry and reviewed by an accredited person(s).